In a speech this week, SEC Commissioner Dan Gallagher said the SEC must act on the opaque fixed income markets and put Reg NMS under the microscope.

SEC Commissioner Dan Gallagher outlined the need for analysis and reforms in both the US equity and fixed-income markets in a speech yesterday. In a speech before the Georgetown University Center for Financial Markets and Policy Conference on Financial Markets Quality, he asserted that investors are doing better in today’s automated stock marketplace than they did when it was dominated by manual trading. Refuting some of high-profile allegations from Flash Boys, including that the stock market is rigged and that it’s “now a class system, rooted in speed, of haves and have-nots,” Gallagher defended technology as helping more than harming investors in the stock market.

Citing research and empirical data, he said the benefits arising from technology include lower transaction costs, improved liquidity, increased market speed, more efficient price discovery, reduced volatility, and expanded market access. However, he said he is troubled by the current market structure in fixed income products, citing “asymmetry of information,” which is more likely to disadvantage retail investors. He also urged the SEC to turn to its attention to systemic risk building the fixed-income markets.

Though retail investors’ participation in these markets -- 72% in municipal bonds and 46% in corporate markets -- is at an all-time high, these markets are opaque to retail investors, he warned. Federal Reserve policies for near zero interest rates have been driving investors into these markets to search for yield despite their opaque nature. “This makes the fixed income markets, and in particular high-yield debt, vulnerable to outflows with only a small increase in interest rates.”

While US bond issuance, totaling $1 trillion, is at an all-time high, and trading volume for fixed income securities of all kinds was $690.8 billion in August, he cautioned that dealer inventory and liquidity in the secondary markets have dramatically decreased. He cited the impact from the Volcker Rule and Basel III to explain why dealer inventories have dropped nearly 75% between 2008 and 2013.

What concerns him is that the fixed income markets are vulnerable to huge outflows should the Federal Reserve raise interest rates. Thus, without the dealers serving as a buffer to absorb the bond sales or holding bonds in inventory for buyers, there is a risk that, when the Fed decides to raise interest rates, outflows from high yielding and less liquid debt could potentially lead to a free fall in prices.

To protect investors, the SEC can address the opacity by requiring greater transparency, he said. Related to the liquidity issues, the SEC can help by “facilitating electronic dealer-to-dealer and on-exchange transactions of these products.” Change can only come if the SEC commits the necessary resources. In order to spark the electronic and on-exchange transactions, SEC needs to push for standardization of bond products. He suggested that bond issuers could agree upon a standard set of terms of debt products -- “a type of ISDA contract for swaps.” The exchange and dealer market must participate in discussions to figure out what rules changes are necessary to facilitate electronic debt market trading.

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Turning back to equities, he said the rules, which the SEC has used to oversee those markets dating back to the 1970s, aren’t able to “keep up with current market operations.” The regulations governing US equity markets date back to the Securities Acts Amendments of 1975. At that time, the New York Stock Exchange dominated trading, while today there are 11 exchanges trading equities and 80 alternative trading systems (ATSs), 40 of which trade equities.

“No sacred cows” in equity market reviewGallagher stressed the need to conduct a “holistic review of equity market structure,” two years ago, but praised fellow commissioners for calling for it and SEC Chairman Mary Jo White for beginning the review and for near-term initiatives. In advocating a comprehensive review of equity market structure, he cautioned the SEC not to blame the markets and participants “for any perceived problems.” Instead, he asked the agency to acknowledge the role that its own regulations may have played in creating those problems.

He laid out three “big picture” items that the SEC’s holistic equity market structure review should cover: Regulation NMS, the self-regulatory model, and securities information processors (SIPs). On Reg NMS, he said it should be put under a microscope to analyze the various assumptions that led the commission to approve it in a contested 3-2 vote and to analyze the unintended consequences that have resulted from its implementation. Noting that two of his predecessors (Commissioners Atkins and Glassman) had objected to Reg NMS because it was viewed as a burdensome regulation, based on “unfounded assumptions of how markets and investors should interact.” They also felt the SEC had not adhered to the Congressional guidelines to allow competitive forces to shape a national market system, and instead had imposed “a series of complex, non-market-based rules.”

Specifically, he called for a review of the “trade-through rule,” which requires orders to be routed to an SRO that displays the national best bid or offer (NBBO). “I believe the trade-through rule is a prime example of regulatory distortion of market competition,” he said. An alternative would be to clarify the broker’s duty of best execution, which doesn’t always mean execution at the best NBBO, adding that FINRA’s best execution rule identifies five factors.

He also questioned whether exchanges should continue to retain their status as self-regulatory organizations or SROs. First, the majority of exchanges outsource their regulatory obligations and market surveillance to FINRA. Second, he pointed out that over 35% of securities transactions are executed through ATSs -- non-exchange platforms.

Gallagher said the current model of two SIPs disseminating consolidated transaction data and consolidated quotation data is a “relic of the 1970s infatuation with utilities.” One problem is the lack of competition between the SIPs delivering last sale and quotation reporting services. Instead, he urged the SEC to look toward providers of direct feeds, which innovate to keep up with competition and technology. He suggested mandating that exchanges make their data feeds available to third party vendors, for a fee, to aggregate the last sale prices, which he said would create competition for consolidated data.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio